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VC Investment in Germany: A People Business

Dirk Kanngiesser & Martin Heinisch, PolyTechnos


Reprint Permission from Aspatore Inc., All Rights Reserved

The Venture Capital Process in Germany is not significantly different from other countries. The three essential elements of a successful venture capitalist investment are stellar management; market traction; and timing by always keeping an eye on promising exit routes.

The elements of the process are:

  • Deal sourcing
  • Due diligence
  • Investment decision
  • Monitoring and support
  • Exit

In Germany, venture capitalists (VCs) source investment opportunities through the typical channels: direct contact by the start-up, syndication VC partners, consultants, research institutes, business angels, corporate/industry contacts, business plan competitions, and media announcements. Upon initial interest, the VC will personally contact the management, who will give the VC a presentation. After the VC completes its internal preliminary due diligence, the parties sign a term sheet and start formal due diligence, which could also involve external support in a number of areas, including technical, market, legal, intellectual property, competition, financial/tax or management analysis. Upon final investment approval by the VC's board, the deal is legally completed and the initial investment amount released. The company becomes part of the VC's portfolio. The VC monitors the company's activities by, for example, taking a seat on the Board, as well as frequent interaction with the management team. Depending on the stage of the company at the time of investment and the VC's philosophy, an exit is typically targeted within five years after the initial investment. During this time, the VC or other VCs may make further investments to cover the negative or insufficient cash flow of the company.

Germany differs from other countries because it has a very strong medium-sized business segment. While well suited for these types of businesses, regulatory provisions, such as tax, legal, and employment, are also applied to start-up companies, which makes life harder for entrepreneurs and VCs. In every country, however, VCs must know how to handle regional peculiarities. Most of the VC-backed start-up companies in Germany go through at least two to three rounds of funding in addition to a potential seed round.

In Germany, power is quite well balanced among the different parties involved in any venture capital investment. Given the current state of the industry, however, entrepreneurs are no longer in as strong a position as they were three to four years ago. Of course, certain types of entrepreneurs are more likely than others to receive venture capital funding. Serial entrepreneurs and technological experts complemented by stellar management teams, for example, will more often receive funds.

Examining Investment Opportunities and Evaluating Risks

When considering an investment opportunity, a VC first considers whether the opportunity fits with its portfolio strategy in terms of stage, region, industry, and deal size. Then, the VC examines the target's technology, market size and growth, team, business model, time to market, total financing requirements, and potential exit value.

When determining the value of a company at the time of the investment, different valuation techniques are used, including discounted cash-flow, market oriented valuation (sales and EBITDA multiples), and discounting exit value.

No significant differences between the term sheets used for pan-European investments and German investments are noteable. The most important part of the term sheet, though, is that one which answers, "Who gets what for which price and under which conditions?" This includes the investment amount, valuation, syndication, milestones, board representation, information rights, preferred rights of investors in case of exit, sale of shares, liquidation, and further issuance of shares. Other important provisions which are usually retrieved in term sheets are exclusivity, confidentiality, representations, and warranties.

When it comes to evaluating risks, experience suggests that a good management team can mitigate many risks. Over time, risk development is closely watched and appropriate action, through board intervention, is taken when appropriate.

Most VCs focus on investing in companies in their home market. They prefer to do deals in other countries only with a strong syndicate that involves at least one strong local party. Most often, this happens in the early stages, either the A or B round. Many VCs, however, have temporarily shifted towards later stage deals, as the scarcity of VC capital available resulted in relatively low valuations for B and C rounds. International syndication of top-tier VCs has become more important. This syndication trend will continue, although to have later stage deals in the medium- and long-term, early stage deals must and will become more popular in the near future.

In terms of the global economy, the industry is currently back at the sound levels of 1997/98. With a growing general economy, the VC industry should be able to continue its long-term growth.

Exit Timeline

Once a VC makes an investment, it looks at a four to six-year timeline in terms of exiting with a greater than 25 percent annual return on investment. Of course, external factors can affect this timeline. Tempting exit opportunities, such as trade sale transactions by strategic buyers, might lead to earlier exits, while bad market conditions may delay a planned exit.

An exit can be executed in several ways, including an IPO, trade sale, secondary purchase, management buy back, and, in unfortunate situations, liquidation.

Management Incentives and Involvement

Stock options and other equity tools are often offered as incentives to the target company's management team. If employee stock option plans (ESOPs) have not already been implemented, they are generally implemented in the course of the investment at typically 10 percent of the total shares.

When a VC invests in a company, it usually nominates one representative to the board of directors. The board of directors is actively involved in all of the strategic issues and receives extensive information and veto rights. On the other hand, they have only little or no operational involvement. A VC seeks to have governance and control rights via special veto rights and through nominating board member(s) rather than getting actively involved in the operational "day-to-day" business of a company.

Changes and Trends

The European VC industry is in line with its volume of 1997/98 (i.e., prior to the IT bubble). A solid and steady growth from these levels can be expected. It shouldn't be forgotten that the VC industry has always been a cyclical industry. The IT bubble, however, resulted in such exuberance that the down cycle has been even more painful. On the other hand, the European VC industry still has to overcome some of its structural disadvantages such as a functioning IPO market.

The VC industry in Europe is still young and has learned many lessons from the bubble. For many VCs it has been the first cycle they had to sustain. What is now required is a consistent flow of exits, thereby returning money to its investors. Then more European LPs can be convinced about the asset class, resulting in more VC capital available. Overall, the gap between the mature US VC environment and the European environment will continue to get smaller.

It can also be observed that the managerial talent and experience of entrepreneurs has significantly improved. In terms of management's compensation plans, the trend will be for entrepreneurs and start-up management to be willing to bear a significant risk by sacrificing part of their base salary for options and bonus payments.

Although the scrutiny of boards has increased, VCs have not changed the way they make up boards. They have always looked for a board complementarily composed of VCs, industry, and technological experts.

In the near future, entrepreneurs should anticipate a longer and more thorough due diligence process and, in response, should start fundraising and preparing the documents early.

Upcoming VC investments will include technology (e.g., networking, semiconductors, displays, micro- and nano-electromechanical systems, power generation & management) and life sciences (e.g., drug development, med-tech, diagnostics) and more and more the interfaces of these areas (e.g. biosensors, smart implants). Companies that develop truly disruptive technologies will especially attract VC attention. Typically, disruptive technologies are associated with a high risk and - in successful cases - with a high return potential for the participants. They have usually a longer "time to market" and require significant cash resources.

Key Advice

The best piece of advice we have ever received with respect to venture investing is that a good management team with a mediocre business idea typically outperforms a mediocre team with a groundbreaking technology or product. On the flip side, we often advise other VCs that it is never too early to assess probable and promising exit routes and to adjust the investment accordingly. To entrepreneurs, we often say that customer focus and generating sales are the important things to focus on from day one. And finally and probably most importantly: VC investment is a people business, or, as my founding partner says, "it's a body to body sport."


About the Authors

Dirk Kanngiesser, Founder and Managing Partner

Dirk Kanngiesser is a founder and Managing Partner of PolyTechnos. He has over 13 years of venture capital experience in Europe. Previously, he worked for eight years as a venture capitalist for Baring Private Equity Partners (BPEP). As a Senior Partner in Europe, he was responsible for German operations and overlooked high technology investments in German speaking countries. Prior to joining BPEP, he served in Brand Management at Procter & Gamble and Project Engineering at Siemens for a nuclear power project.

Dirk is a board member of a number of high tech companies. He has also served on the board of venture capital funds such as Capricorn Venture Partners and the EuroMerchant Balkan Fund. Dirk is a member of the EVCA High Tech Committee.

Dirk received his degree in electrical engineering from the Technical University of Dortmund in Germany. He received his MBA from the University of Michigan.

Martin Heinisch, Investment Associate

Martin Heinisch joined PolyTechnos in April 2002 after having graduated in Business Administration at the Ludwig-Maximilians-University Munich. He received a scholarship for the MIT Sloan Visiting Fellow Program and graduated from E-Lab. His studies were primarily focused on entrepreneurship and finance, and additionally he participated in an interdisciplinary program together with computer scientists and electrical engineers.

About PolyTechnos Venture-Partners

PolyTechnos is an independent European venture capital firm with the objective to nurture technological innovation and to guide exceptional entrepreneurs in growing world class businesses for the benefit of its advised funds' investors and the society.

PolyTechnos focuses on privately held technology and life science companies in early to expansion stages of development, predominantly in German-speaking Europe. Areas of expertise comprise Information Technology & Communications, Industrial & Engineering, Energy, Drug Development, Diagnostics & MedTech, with a special interest in developments at the interface of these fields. The PolyTechnos team combines long standing venture capital investment experience with broad international operational and management expertise based on strong technology and life science backgrounds. PolyTechnos helps companies turn technology into business by providing support in areas such as strategy, business development, and organisation building. PolyTechnos, located in Munich, Germany, was founded in 1998 and currently advises funds totalling approximately EUR 200 million.

PolyTechnos is a full member of the European Venture Capital Association (EVCA) and the German venture capital association (BVK - Bundesverband Deutscher Kapitalbeteili¶ðgungsgesellschaften).

For more information on PolyTechnos, please visit www.polytechnos.com.